Do you suffer from this investing bias?

(May 18, 2013)

In this issue:
» Where is Euro headed?
» Why is management often reluctant to write down goodwill?
» Cheap liquidity is driving the market rally
» Will the 'junk rating' hurt India's recovery?
» ...and more!

00:00

Any investment that you make has essentially two outcomes. Either it will succeed or it will fail. Of course whether it will succeed or fail depends upon the kind of effort one puts in to know the business and fundamentals of the company. The price at which one buys is also equally important.

Despite being cautious and following a long term approach to investing there could be some rotten apples in your basket. In other words, companies that fail to deliver as per your expectations. Now what should one do in such cases? Obviously the answer is 'Sell the stock'. However, that is easier said than done.

There is a general tendency amongst people to hold on to underperforming stocks. Basically they hold on to these losers for long until the stocks decay. This unwillingness to exit bad stocks is called 'loss aversion bias'. The very thought of exiting the stock instils a fear of regret in investors. The regret pertains to making a wrong investment decision and losing money. It is an emotional trap. In short for emotional reasons, many do not have the courage to book loss on a poor investment decision.

However, investing is not just all about fundamentals, valuations and businesses. It is also about emotions. This is because we as human beings take the buy and sell decisions. And our decisions are governed by our emotions. Thus, apart from having a strong knack to understand businesses having a strong emotional intelligence quotient (EQ) is equally important to be successful in investing.

One who can block out his emotional side and take rational decisions based on the facts presented will more often than not end up on the right side of the coin.

Take the case of holding on to losers for long that we just mentioned. If one were to purely evaluate the company on the basis of its fundamentals, keeping emotional biases aside then taking a prudent exit decision will not be difficult.

Apart from not allowing investors to exit the losers, emotional biases also induce investors to sell winners too soon. How many times have you exited the stock after registering a minor gain and later see the stock rally further?

While it is fundamentals that decide what businesses to buy and sell it are our emotions that decide when to buy and sell. One who can balance both is on the right path.

Indian corporates' liking for overseas capital is well known. Not only is the capital abundant in foreign markets but it is also cheap. This is because interest rates in foreign markets are lower than in India. But interest rates are relevant when it comes to borrowing via debt. Apart from debt which comes in the form of foreign currency convertible bonds and external commercial borrowings (ECB's) corporates can also raise equity capital from foreign markets. This comes in the form of American Depository Receipts (ADRs) and Global Depository Receipts (GDRs). Raising capital via this mechanism enables foreign investors to participate in India story without taking any currency risk. On the other hand, listing in overseas markets gives the subject company a global platform.

Considering the recent slowdown in overseas markets the appetite of raising money via ADRs and GDRs has dried up. It can be seen from the chart that in all the 4 quarters of FY12 money raised via both these instruments was higher than in FY13. In fact, in 4QFY13 not a single Indian company managed to raise a penny via these instruments. It is not that Indian corporates have sufficient liquidity and they don't need to raise capital. The reason for dying faith in these instruments is that foreign investors are a bit circumspect about putting their money in India right now. Hence, Indian companies are unwilling to raise capital via this mechanism. We feel that unless the global environment improves such a dry spell is likely to continue.

Data source: SEBI

02:05

If you're wondering what will be the fate of the Euro in the near future, a couple of Deutsche Bank analysts might have an answer for you. They are of the view that there are strong chances that the common Euro zone currency could depreciate significantly. This of course sounds counterintuitive at first. If economic scenario in a region is improving, then the currency should rise and not fall, isn't it? But take your mind back to the crisis of 2008-09. Here, during the crisis, the US dollar shot up but then fell later as risk of crisis abated and investors diversified into other assets. Thus, exactly similar could happen with the Euro. Here, the Euro went up as investors rushed to safe haven when risk of economic contagion increased. But now with situation improving, people will move out of Euro and thus, make it fall. But is it fair to assume that a second event will pan out in exactly the same way as the first one? Even if the underlying currencies and the economies involved are different. We don't think so. And precisely the reason why we don't like to predict things in the short run. This is not to say that long term predictions are always correct but certainly have a greater chance of proving themselves correct if analysed properly.

02:30

Goodwill. We are referring to an accounting concept that companies love to use. Goodwill is the excess of price paid for a company's assets less its liabilities. So it is the excess amount that cannot be accounted for by the acquired company's net assets. As per the accounting norms this goodwill should be tested for impairment every year. If the value of the asset no longer deserves the premium that is represented by the goodwill, then it must be written down. But goodwill impairments are rare. As such managements are reluctant to write down goodwill soon. Why is this so?

An article in the Economist blames management egos for this. The managements of companies typically wish to portray that acquisitions, no matter how expensive, are justified for long term growth. Like any other investment if the acquisition is made at super expensive valuations then it does not yield returns to the company.

See the case of Tata Steel's acquisition of Corus. The company has recently stated that it would be taking a write off in the goodwill for Corus. But why did it take them 5 years to realize their mistake? Or have they even realized their mistake of acquiring a company at valuations that did not justify the fundamentals? These are questions which all normal investors would be asking at this point of time. Corus has been weighing down the results for Tata Steel for a while. Given the crisis in Europe, its outlook continues to be weak. Such events make you question whether building goodwill through acquisition makes sense in the first place. Valuations are of utmost importance in every form of investment. Irrespective of whether the investor is an individual or a company. The rules remain the same.

03:05

Macroeconomic indicators in the developed markets since the financial crisis in 2008 have remained weak as ever. And yet if one looks at the global stock markets, the rally in the past few months only highlights the disconnect between the two. The major reason for this rally can be attributed to the central banks' easy monetary policy. With money being available so cheaply, it is finding its way into stocks. This has only served to increase prices. But that is not all.

According to an article on Bloomberg, there is another worrying factor at play. And that is whether the money that is being poured into equities is the investor's own money or is it borrowed. If it is latter, it raises the possibility of another bubble in the making. Leverage is dicey for the entire financial system. This is because it has the potential of turning what seem as isolated losses into widespread disasters. Post the crisis, there has been calls for greater regulation in the financial system. But a better way of creating data on leverage has yet not evolved. Perhaps, if more importance is given to this issue, some understanding can be gained of the potential risks that the financial system will face.

03:30

The government had barely heaved a sigh of relief. Inflation numbers showed signs of cooling off. Lower fuel subsidy and correction in commodity prices were also easing worries on the fiscal deficit front. But even before the Finance Minister could wipe the sweat of his brow, here comes yet another warning.

Rating agency Standard and Poor's (S&P) has warned that there is more 30% chance of India's sovereign rating being downgraded to junk status in the next 12 months. This is threat that is bigger to the Finance Ministry more than any other. For it will completely seal the prospects of economic recovery. For one, the junk status will dramatically raise the overseas cost of borrowing for Indian companies. Secondly, it will also adversely impact the country's image as a foreign investment destination. As per an article in Mint, international institutional investors have already invested over US$ 17 bn in India so far this year. The downgrade in rating will be a huge setback to them.

Although S&P's credibility and reputation in terms of quality of its ratings has hardly recovered since the 2008 subprime crisis, the 'junk status' threat is something that India cannot afford to ignore.

04:10

Barring Hong Kong (down 1.0%), the major global indices ended the week in the green. The US stock markets gained 1.6% over the week on the back of positive economic data and strong corporate earnings. The labour market and retail sales data in US have shown an improvement and consumer sentiment is at its highest in nearly six years. The future economic activity data for US also showed a rise (around five year high) in the month of April.

The European stock markets witnessed gains, backed by positive economic data from US. Among the major Asian markets, the stock markets in Japan led the gains (up 3.6% over the week) on the back of a positive quarterly GDP data suggesting that recent stimulus intervention programme might be paying off. The stock markets in China witnessed 1.6% gains over the week on hopes of economic reforms.

The Indian indices closed the week on a positive note. The gains in Indian equity markets
were mainly driven by foreign liquidity and hopes of a rate cut as the data on wholesale inflation suggested some easing. The BSE-Sensex
gained 0.9% over the week.

Data source: Yahoo finance

04:50

Weekend investing mantra

"Individuals who cannot master their emotions are ill-suited to profit from the investment process" - Benjamin Graham

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Your article is bang on. I realize that I suffer from 'Loss aversion bias'I purchased SKumar Synthetic Fibre stocks Rs.33/- in April, 2012 and now it is at Rs.4/-! It has been steadily losing from the time I purchased but, I could not bring myself to sell it at loss. Now it is as good as my money is lost.

Yes, I bought stock name called S&Y Mills. Now that company is taken over by someone else. I could hardly see the taken over company coming up with it's performance. S & Y Mills trading at 10.08 paise. Pl guide me how to get my money locked in this scrip though it's a loss.

What you have mentioned is correct.I had pacific cotspin which I a purcgased and forgot about it since I was out of india .When I came bak the prie had dropped to re1.Waht do you do in such a case.Who will buy this share so I am still holding on to it.For pratical purpose I have written off thi investmant.Any comment

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